4 Steps to Build a Solid Investment Thesis


Dividend Guy Blog Logo SmallMany readers ask me how I make my sell decisions. I have only three sell rules and most of my transactions are explained by the first one. I sell when:

  1. The company doesn’t match my investment thesis anymore.
  2. The company cut its dividend (a few exceptions apply amid COVID-19).
  3. The company has grown too much in my portfolio (Apple was worth about 15% of my total investments at one point).

As you can see, the investment thesis is at the center of most sells. Here’s a recap of my personal sell transactions over the past 24 months:

March 2020, Lassonde: Here was the investment thesis for Lassonde:

“Lassonde’s wide variety of brands enables it to occupy an important space in grocery stores. There aren’t many consumer products in Canada with such great metrics. LAS will continue to surf on many healthy products and to generate enough cash flow for future acquisitions. LAS recently completed a cost reduction program which should result in margin expansion. Lassonde’s share price tumbled during the second half of 2018. Earnings are under pressure. Higher transportation costs in the U.S. are hurting the company’s margins. Revenue growth has been mostly supported by currency tailwinds and the acquisition of OBB. This looks like a great opportunity, but shareholders must remain patient.”

Here’s what I wrote in my March newsletter:

“Unfortunately, when I read my analysis about Lassonde, I must humbly accept that I was wrong. The company does offer great products and enjoys strong brand recognition in Canada, but Lassonde can’t grow outside acquisitions. Its expansion in the U.S. has been proven more challenging than anticipated…”

March 2020, Apple: I had to rebalance and sell a few shares since AAPL was taking too much weight in my portfolio (15%). I would have kept all my shares otherwise.

January 2020, Garrett Motion and Resideo Technologies: Those were spin-offs from Honeywell, and I was not paying close attention to selling them earlier due to their minimal values in my portfolio.

January 2019, Honeywell: I had BlackRock (BLK) on my watch list for a very long time and when I had the opportunity to buy it at $400/share, I jumped on it. Honeywell was the “least interesting” position I had at that time. In an ideal world, I would have kept both, but that’s the downside of being 100% invested all the time. I must sell something when I see a great opportunity.

In the end, I made 3 sell transactions (considering the spin-off part of Honeywell) in the past 24 months. I’d like to emphasize the importance of making relatively few transactions and trusting in your process.

From those transactions, one was about being wrong with my investment thesis and another (Honeywell) was about finding a better opportunity. In other words, I considered my investment thesis for BlackRock to be stronger than the thesis I had in place for Honeywell.

To help you understand how I build my investment thesis, I’ll review my straightforward process. I will apply these steps on the two companies mentioned before on this blog: Lassonde Industries (LAS.A.TO) and FedEx (FDX)).

#1 Define what should go well

Defining what should go well about a business comes down to making a comprehensive list of what makes this company great and how it can continue to grow in the coming years. Here’s a short summary of my initial investment thesis for all four companies (they have changed overtime as I was wrong).

LAS: LAS enjoys strong brand recognition and counts on stable market share. The company is currently expanding in the U.S. through acquisitions. LAS will continue to surf on many healthy products and to generate enough cash flow to fund future acquisitions.

FDX: FDX has proven it can go through oil price crises, recessions, and even cyber-pirate attacks, and still reward its shareholders. FDX and UPS dictate the delivery market by their size and their efficiency. FDX manages an impressive fleet of delivery assets, and remains the world’s largest express delivery provider.

As you can see, each company represented a solid investment with several reasons why it would continue to grow. But positive points aren’t enough to build a solid investment thesis. You also need some gloom and doom to make sure you understand the entire business model.

#2 Define what could go wrong

Once you get all excited about growth possibilities, it’s important to get back down to earth and understand what could go wrong. If you define the potential risks correctly, you will be in a better position to make sell (or hold) decisions when things turn sour. There are industry risks that are usually cyclical where the business can manage and eventually thrive. There are also risks that are specific to the company and will likely be a major blow to the business model.

LAS: Lassonde is battling against major brands, such as Minute Maid (Coca-Cola) who have larger budgets. This could affect its sales over the long run as it can’t really compete evenly with them. The fact LAS has entered more significantly into the US market shows management isn’t afraid of competing, but this confidence could penalize them if it proves to be arrogance. Higher transportation costs will hurt Lassonde’s margins and make them less competitive. Since the dividend is paid according to EPS fluctuations, it will fluctuate each year.

FDX: FDX is highly exposed to a possible international economic slowdown. When you look at Europe slowing down and the remaining commercial tensions with China, it’s hard to believe that the global economy will surge in the upcoming quarters. The impact of COVID-19 is not fully known, but that’s just another challenge FedEx will have to manage. Keeping such a large air fleet busy is very costly, and FDX will have to support these charges during the recession. The acquisition of TNT Express hasn’t been generating the expected results, either. This weighs on FDX’s cash flow generation and ultimately on its dividend growth policy. Finally, Amazon is quickly growing its delivery capacities and should become a strong competitor going forward.

Lassonde suffered from tight cash flows due to an important acquisition at the same time as the COVID-19 stroke. As the pandemic pushed the world into a recession, it was the worst timing for those companies. They all thought the economy would grow in 2020 and everything fell apart after the first quarter.

FedEx enjoyed the opposite situation. The virus propelled e-commerce 10 years in advance within a few months. Parcel delivery became trendy and the company enjoyed additional market love.

Once my pros and cons list has been completed, I like to compare it with others. The point here is not to cheat and “build” my list with answers from other investors. I want to compare to find other points and view the company from a different angle. Here’s how you can do it.

#3 Compare your analysis with others

Members over Dividend Stocks Rock will often hit our Stock Cards. By reading through our analysis they are able to find a different point of view. They may or may not agree with our analysis. In both cases, it will bring them one step further in their comprehension of the company. I know it’s tempting to skip step #1 and #2 and go directly to reading analysis. If you do that, the seed of doubt will be easier to plant in your mind during the challenging times since you won’t be looking back at your own analysis. Therefore, it’s always better to have your own ideas about a company.

Another resource where you can find plenty of free analysis is Seeking Alpha. I like reading their articles which may present an alternate point of view.

#4 Review your thesis quarterly

The final point around the investment thesis is the step where you make the decision to sell or keep your holdings. I do that quarterly. As mentioned earlier, with 3 sells in the past 24 months, it’s more routine work than anything else. I can’t stress that enough: the point is not to sell many positions during each review.  You must trust the process and let the process lead you to take appropriate action.

By reviewing each quarterly earnings report, I try to make sure I didn’t miss anything earlier, and I can hopefully anticipate what is coming up next.

Lassonde struggled for several quarters in a row with the same problems: difficult integration, margin pressure due to higher costs of operation (and lack of synergy). After a few quarters, I noticed that I was wrong about my investment thesis. The potential risks were bigger than the growth opportunities.

Finally, I dropped the towel too soon on FedEx. The stock posted strong guidance recently and the market got all hyped about both UPS and FDX. As you know already, UPS is on my watch list right now as I believe damage done during the upcoming war with Amazon (AMZN) will leave some scars. I’m not convinced UPS (or FedEx) will win.

Final Thoughts

It’s OK to be wrong sometimes, if you are right most of the time. That’s the whole point of managing your portfolio on your own.

When I look at my past mistakes, many of them could be explained by unpredictable events and part of it is plain and simple: I was wrong.

Keep in mind that each time you make a trade decision (a buy or a sell), you expose yourself to being wrong. Therefore, the secret is to minimize the amount of trades and focus on a well-built process. I don’t mind keeping “mistakes” offering small returns for a period if I have other positive investments to compensate for those negative decisions. Plus, who knows, some of those presumed mistakes might quickly transform into great investments within a few months!

The post 4 Steps to Build a Solid Investment Thesis appeared first on The Dividend Guy Blog.

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